Economy grows slowly after bust

The global economic outlook has improved in just a few weeks. In early March, there was a lot of doom and gloom and the stock markets around the world were setting new lows. Since then, pessimism has diminished. Most stock indices have recorded double-digit gains. Since the stock market tends to lead the economy by about six months, we could be seeing the light at end of the tunnel for the economy. Is the optimism justified?

To be sure, there are good reasons for some optimism. Consumer confidence seems to have hit the bottom. In parts of Southern California, home sales are rising at double-digit rates. As home prices have fallen as much as 50 percent to 60 percent from their peak, potential home buyers are out looking. Mortgage rates have hit a very low level boosting home sales. The combination of falling prices and low interest rates has increased the affordability of homes dramatically.

According to the consumer confidence survey by the University of Michigan, American consumers said it is a good time to buy houses and cars. If credit availability and jobs weren’t constraints, the consumers would be more excited about buying cars and houses. For many big-ticket items, production has been plunging at a much faster rate than sales depleting inventories. If sales begin to stabilize, production will start increasing to rebuild inventories.

The dramatic decline in crude oil prices has been like a $250 billion tax-cut to American consumers. However, the commodity prices have stabilized and begun to rise.

Despite these positive signs in the economy, the road ahead is not clear. The optimism could be overdone.

The biggest problem is the job market. The jobless rate in the U.S., which is at 8.5 percent now, will hit 10 percent sometime early next year. Businesses won’t start hiring people until they are very sure that the economic recovery is going to be sustained.

After a financial bust like the one we are experiencing, history tells us that the economy grows slowly afterward. The cause of the current economic contraction is very similar to the one preceding the Great Depression. However, there are other reasons for expecting slow recovery when it comes.

First, the American consumer, which had pulled the global economy forward, won’t spend as much as it used to. Second, the dysfunctional credit market won’t allow American consumers to spend beyond their means. Credit is all about trust and confidence. Once they are broken, it takes a long time for them to be repaired.

Third, the wealth effect is another factor turning against consumer spending around the world. In the U.S, every $100 increase in the value of real estate or stocks used to boost consumption by about $4. Fourth, before the current economic setback began, the American consumers made the global prosperity and increasing trade possible. As American consumers embarked on a spending spree, the exports of many Asian countries shot up.

The net result of all those factors is that international trade will stagnate in the future. Trade-dependent countries such as China and Korea will no longer be able to rely on exports to drive its economic growth. As global trade slows, U.S. economic growth will be adversely affected.

Technically, economic growth can rebound sharply as inventory runoff turns into accumulation. However, the underlying strength of the economy will be weak.

— Sung Won Sohn is an economics professor at the Martin V. Smith School of Business at CSU Channel Islands.